The Roots of the Financial Crisis

October 2nd, 2008

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To paraphrase a famous saying: the road to financial ruin was paved with good intentions.

But to understand what has happened, you have to start with understanding the role that finance plays in the economy.

This begins with the basic capitalist act—starting a business to make a profit. This process starts with a leap of faith that putting up money today will lead to more money in the future. Even established companies are constantly expanding and changing product lines to respond to the signals from the market. To do this, they are either risking previous profits or having to finance new activities.
Consequently, companies always need money at the beginning of each production cycle. This money can come from the individual business proprietor, a small group of people (partnerships), a large group of people (corporate stock) and loans from banks and individuals (bonds). The difference between “equity financing” and “debt financing” is based on how the future profits are provided: lenders are paid first at a fixed rate of return while the owners divide the profits which can vary widely.

Companies turn to debt financing because they don’t have enough capital themselves or as a profit maximizing strategy. To understand the latter approach, consider the following two ways of funding a $100 million project that is expected to last one year and generate revenues of $112 million. For the owner who puts up the entire amount, the profit rate is 12%. An alternative way of financing this project is to borrow $50 million and personally invest the other $50 million. If the interest rate of the loan is 10%, then $55 million must be paid back to the bank at the end of year, resulting in a profit of $7 million or 14% return on the investment.

In financial parlance, the use of the loan permitted the investor to “leverage” his $50 million into the $100 million he needed. If sales in this example turned out to be $106 million rather than the planned $112 million, the profit rates on the two financing schemes change dramatically. In the first case where the investor put up the entire amount, the profit rate would be 6%. The leveraged investor, on the other hand, would still have to pay back $55 million leaving only $1 million of profits or a 2% rate of return on his $50 million. Even worse, if sales turned out to be $96 million, the owner’s loss would not be $4 million but $9 million (because he still would have to pay the bank $55 million). So, the use of debt financing magnifies the risks and rewards of the equity owners.

In addition to loans to businesses for production activities, consumers and government are also users of debt financing. In most cases, the borrowing is used to finance activities whose benefits are spread out over many years. For the public sector, this means public works and transportation activities. By contrast, loans to consumers were originally for home mortgages only. By requiring large down payments, lenders seemed to be protected because they could foreclose and sell the home at auction to recover the outstanding principal.

This broad stroke outline of finance shows that it performs many useful functions. A counter-intuitive statement is that debt is democratic. Although borrowers worry about repayments, using debt enabled them access to resources, be it a new house, furthering their education, or starting a new business. As Glen Yago puts it: “In the absence of inherited wealth or the granting of seigniorial rights to property, debt has been a central tool for acquiring productive assets.” {reference: Junk Bonds: How High Yield Securities Restructured Corporate America, New York and Oxford: Oxford University Press, 1991, p. 109.}
The next step is to follow the money and find out where the money for loans comes from. Instead of dealing with person-to-person transactions, institutions develop to combine small amounts of money from many people into a common pot. Banks then are “intermediaries”—they collect money from one group of people and then make it available to another group of people. They make a profit because they pay their depositors less than they charge for their loans.

They can only do this because all of the depositors do not ask for their money at the same time. Hence, they only have a relatively small proportion of their assets readily available (“liquid”) to meet the normal flow of money in and out of their accounts.

As intermediaries, they are mainly dealing with other people’s money and there are many different ways in which the system can break down. Because time and risk are so integral to this process, banks loans are just claims on future money streams. Of course, banks expect some loans not to be repaid but there are unexpected downturns that can lead to a higher than anticipated rate of default.

To account for this potential, banks are supposed to keep a reserve that not only includes a fixed share of depositor’s money but a sizable amount of money from the owners of the bank. Banking practices are supposedly made to be “prudent” because the first money that is applied to losses is the capital of the owners.

A run on a bank occurs when depositors feel that the bank is about to become bankrupt. As many people show up at the door at the same time, the bank is unable to provide the cash and must close its door. This is what happened at the beginning of the 1930s (and happened in Argentina and Uruguay as recently as 2001). To combat this happening again in the US, a series of new regulations were imposed (culminating in the Glass-Steagall Act of 1933) creating federal deposit insurance, new oversight of banks with higher capital requirements, and a strict division between different types of financial institutions.

Once the economy rebounded strongly after World War II, banking became a boring business that one analyst called “3-6-3 banking”—pay your depositors 3%, lend at 6%, and be on the golf course by 3 PM. Savings and Loans banks were particularly hemmed in by regulations that limited what they could pay depositors and the fact that they lent money for long periods of time (they were predominantly home mortgage lenders). The high inflation of the 1970s put them in an untenable position such that in 1980, 85% of the 3,800 federally-chartered S&Ls were losing money.

The deregulation movement that began in the 1970s picked up momentum with Reagan’s push for ‘less government.’ One of the first major pieces of financial regulation was the Garn-St. Germain Act of 1982, which freed the tight reins on the S&Ls. In many ways, this attempt to rely on the market was too late and misguided. Many S&Ls had lost their capital base and were truly playing with other people’s money. Because they had nothing to lose, they made big bets on loans to risky projects (that had high interest rates) hoping that they could recoup their lost capital.

Regulators were denounced for ‘harassing’ S&Ls, even though they were trying to ensure that insolvent banks were forced to close. When the desperate attempts to win big with risky loans failed, there were a series of high profile bank collapses. In the last years of the 80s, the number of S&Ls shrunk by 50% and 1,400 commercial banks had closed or received federal assistance.

The 1980s witnessed many other dramatic financial events. On the negative side, there was the rise of high yield “junk bonds” to facilitate mergers and acquisitions. The famous decade of “greed” led to a handful of high-profile convictions of insider trading. The most famous example was the junk bond king himself, Michael Milken. Although sentenced to 10 years, he only served 22 months and was fined $200 million. But 20 years later, his current net worth is estimated to be $2.1 billion.

On the positive side, the rise of venture capital facilitated the growth of a series of high tech start-ups –e.g., Microsoft, Netscape, Intel, and Cisco—that would lead in the economy in the 1990s. At a World Economic Summit ten years ago, it was widely agreed that only in America could such companies start out with an idea and grow to multibillion operations within 10-20 years.

The rise of these companies also fueled a wild run-up in stock prices. After gaining ground in the 1980s, there was a pause for a few years at the beginning of the 90s. But from 1993 to its collapse in 2000, a tech-led rally led to wild optimism with some people seeing the Dow reaching into the stratosphere for decades to come.

In this environment, the urge to strike it rich led to new financial strategies. The “quants” arrived on Wall Street with sophisticated trading programs that seemed to guarantee success. No one was better placed than Long Term Capital Management (LTCM) which included two Nobel economics prize winners at its founding in 1994. It did not disappoint with a 40% rate of return in its first year but then crashed in 1998 following huge losses after the Russian government defaulted on their government bonds. The ‘sure fire’ strategy of LTCM was based on differences in yields between similar classes of assets. LTCM bet that the price of Japanese and European bonds was too low relative to American bonds. When everyone one rushed to the security of American bonds, LCTM lost nearly $2 billion in a matter of weeks.

But this rise and fall was quickly forgotten as a variety of institutions developed new ways of leveraging investment for maximum gain. Two things happened in the late 90s that set the stage for the current crisis. First, the Clinton administration encouraged the mortgage industry to find ways to expand home ownership to high risk, often low-income families. Second, the limits of Glass-Steagall were abolished with the passage of Grahm-Leach-Bliley act of November, 1999.

Neither September 11th, the tech stock crash, the LTCM collapse, nor the S&L debacle of the late 1980s led to any significant pressure to regulate financial activities in the 2000s. Instead a low-interest rate environment created the perfect conditions for a housing price explosion and home ownership rise.

The Clinton and Bush policies of serving the poor seemed to be working—the home ownership rate, which had been stuck at about 64% from 1975 to 1995, rose to 69%. But without adequate regulatory controls, this advance was done in a crazy way. At one point, getting a home loan required 50% down; in the 1950s, the rule was relaxed to a 20% down payment. Slowly the conservatism of bankers was lost as the lending standards kept on getting lower. First, it was 5% down, then it was nothing down, and then it was no requirement to document one’s assets and incomes.

The incentives for loan originators—they were paid on the basis of how many loans they could sell without much consideration of what the future default rate would be—led to remarkably poor financial practices. In many cases, people were enticed into agreeing to loans that they had very little chance of paying off. In particular, teaser rates on adjustable rate mortgages meant that someone could afford the original payments but could not sustain their payments once the rates were reset.

On top of this, the rating agencies became enablers of the craziness. Packing loans and selling different components as separate securities potentially is a great way to add more money to the mortgage market. But with little historical experience to go on, the rating agencies rated very weak bundles of mortgages as being very financially sound.

This combination of events was bound to fail in a big way. One day, housing prices would stop going up; one day people who did not have the incomes to support a mortgage would lose their homes; one day, adjustable rates would mean that people couldn’t afford the payments; one day, speculators who were flipping houses would get caught with a property worth less than they bought it at; and one day people who were taking out second mortgages or home equity loans would find that they owed more than the current value of the home. Because of the linkages between these events, each negative trend would reinforce the others.

The housing price bubble bursting would have caused problems under all circumstances. The problems would have been huge considering how many inappropriate borrowers were given loans with no down payments. While this was not sustainable, a downturn in the housing market would not have caused the current financial implosion without the expansion of exotic financial instrument based on “securitizing debt,” leveraging investments, and hedging against loss.

The principles of these strategies are fairly straight forward. In the past, the banks that originated the loan held that loan through maturity. The new innovation was to have a financial entity buy up lots of mortgages and then create bonds that were backed by the monthly payments of the borrowers. But the loans were not simply packaged, they were divided into various groupings (called “tranches”) based on their risk.

Things got really off track for three reasons. First, the rating agencies were unprepared to evaluate these different bonds and used a sloppy approach in saying that even bonds with very risky loans were themselves quite safe. Second, a lot of the purchasers of the bonds leveraged their investment by purchasing them with loans and thus exposing themselves to large losses when the bonds underperformed so badly. And third, in order to protect against risk, a new set of instrument financial instruments were used (e.g., ‘credit default swaps’). But these back-up protections were not adequately funded and were not financially viable during a big downturn.

So when the housing market collapsed, the financial structure behind the mortgages has so many instrument intertwined that any localized problem would rapidly spread throughout the international financial system. Even after a year and half of housing price declines, it is still uncertain where the losses are. And since no one knows the quality of lots of assets, there is an erosion of trust and people are hesitant to make deal with firms that may collapse in the future. Without this trust, markets ‘seize up’ and you can’t turn your assets into cash to repay your obligations. When you can’t sell them, firms have to make up a price to determine the value of their assets. When people know lots of people are making up a price, confidence declines yet more.

The main lessons of this history are that it is very easy to misuse other people’s money and that unforeseen events happen. We are paying dearly for many people forgetting these lessons and blithely increasing the number of financial instruments. Financial innovation when done right allocates capital in an efficient way and can price risk at the appropriate level. But when financial deregulation leads to too little regulatory oversight, it is a certainty that a number of people will overstep the line. When things go well for a period of years, it is a certainty that the line will be pushed that much further back from sustainability and that the resulting meltdown will be that much larger.

Finance was meant to facilitate the functioning of production and consumption. Instead it has become the hub of the system by centralizing huge amounts of money. In addition, there has been a transformation from the stolid, conservative banker to aggressive risk takers.

Their sophisticated use of mathematical models has identified trends that are rarely broken. Unfortunately, the key word here is ‘rarely’ and not ‘never.’ They misunderstood how time could work against them. The people who bought out the remains of LTCM actually made a profit on the remaining positions. But LTCM did not have the luxury of waiting out the market once their huge bets went bad leaving them without any cushion to pay off desperate customers.
Managing risk is not the same as avoiding risk. And as long as people are using other people’s money, the titans of finance will use money in a way that lines their pockets. As the Milken example shows, even if caught and punished, the rewards are very high.

So what can we expect in the future? Certainly a lesson has been learned, much as investors learned a lesson from the technology stock crash. At this moment, Congressional leaders have realized that the stakes are too high and have agreed in principle to a massive bailout of the financial industry. After watching the failure of Lehman Brothers and the government takeovers of Fannie Mae, Freddie Mac, and AIG, leaders of both parties wanted to send a strong signal that the federal government was going to provide liquidity to markets that were not functioning. It is possible that a meltdown would not have happened without this intervention, but many people did not want to take this risk.
Understandably, the public is not happy because the people who caused this mess are not bearing the costs of clean-up. There are currently ongoing FBI investigations of a number of financial institutions to determine whether financial executives lied about the state of their companies. This is going to be tough to prove with perhaps only a couple of cases going to trial. The real problem was that financial leaders were just doing what they were paid to do—seek out more profits and fees for their company. They not only collectively underestimated the risks; they created so many different layers of instruments that few knew where the bad assets were.

After the election, there will be a push for reforms. Despite his recent tough talk, McCain has prided himself as being a deregulator so it is hard to see him pushing for strong limits on what financial institutions can do. While Obama seems to understand that the financial architecture needs to be changed, the political power of financial leaders is very great, even inside the Democratic Party. So reform will be an uphill battle under all circumstances. Certainly we are never going to see the practices that led to the explosion of sub-prime mortgage lending. And the magnitude of this bailout means that people will be hesitant to go down this road again soon. But memories can fade and without a lot more oversight and regulation, we may face another round of financial bubbles bursting a number of years into the future.

This article is reprinted from stats.org